Bank’s Size Counts More on CEO Pay

If you pay peanuts, you get monkeys. The adage is often heard when discussing executive pay on Wall Street.

But what happens if you don’t pay peanuts but millions of dollars a year, as many large U.S. banks do? You should get superior stock price performance.

Unfortunately, new research suggests that pay is much more linked to a bank’s size than its performance–a finding that could complicate regulators’ efforts to shrink financial groups.

The issue of pay will be front and center in the next two weeks when shareholders participate in nonbinding votes on executive pay at Goldman Sachs Group Inc., Morgan Stanley and J.P. Morgan Chase & Co. One of the two main firms that advises pension funds on these matters, Glass, Lewis & Co., has recommended “no” votes on all three, arguing that the banks’ performance doesn’t justify the 2013 pay packages. (The other one, Institutional Shareholder Services Inc., is urging “yes” votes.)

The question of how much, and how, to pay Wall Street executives has taken new urgency since the financial crisis because tougher rules and lackluster markets have crimped the profits of large banks.

That is why Frederick Cannon, an analyst at Keefe, Bruyette & Woods Inc., set out to measure the link between pay and performance at both the nation’s largest banks and their smaller peers.

His conclusion: Investors in large financial groups are suffering when compared with smaller banks but their managements aren’t. Mr. Cannon blames this state of affairs on the watchdogs. “Regulators have created a situation where their policies are penalizing shareholders but not the decision makers,” he told me.

The starting point here is that large “universal” banks such as Goldman, J.P. Morgan and Citigroup Inc. have underperformed smaller rivals when looking at total shareholder returns–share price performance plus dividends.

The eight financial groups deemed “globally systemic” (i.e. capable of threatening the world’s economy) have seen total returns rise by a median of 38% since the end of 2009, according to KBW. By contrast, banks considered “domestically systemic,” such as U.S. Bancorp, PNC Financial Services Group Inc. and SunTrust Banks Inc., had median total shareholder-return growth of more than 100%. Judging by the market valuations of the two groups, that gap will continue.

The next step is to look at executive pay. Unsurprisingly, the chief executives of the big banks come out on top. Between 2010 and 2013, the median total pay, including cash and stock awards, of the CEO of a large bank was more than $57 million, $22 million above the median compensation for the chiefs of smaller firms, according to Mr. Cannon’s research.

What drove these paychecks? Not performance but size. Mr. Cannon found no apparent links between compensation and shareholder returns, but he did discover a robust connection between a bank’s assets and its officers’ pay.

“There is strong evidence that size has been the key driver of bank executive compensation since the financial crisis,” his note concludes.

In itself, there is nothing wrong with large banks’ chiefs earning more than those running less complex institutions. But the real issue is whether the current system pushes those executives to do the right thing when it comes to strategy.

Much of the postcrisis regulatory changes has been aimed at curbing the size of balance sheets to make banks less risky. But the study suggests that management teams have a lot to gain from continuing to expand banks’ assets.

Conversely, there is little or no incentive for executives to consider spinoffs and other corporate actions that would make their banks smaller.

Take Citigroup, for example. Its shares have been trading below tangible book value–a measure of what shareholders would receive if the company broke up–for a while.

The market believes that Citigroup’s parts are worth more than the whole. But the current system gives Michael Corbat, the CEO, and his team, a powerful reason to retain the status quo: their pay.

In theory, the board, or an activist investor, could prevail upon the executives and force them to look at a breakup, but no company could possibly conceive such a radical plan without management’s say-so.

In a statement, Citigroup said its strategy “is designed to leverage our unique footprint to generate returns for our shareholders and for that reason alone.” The bank added that its pay structure, which was redesigned last year, “better aligns compensation with performance and shareholder returns.”

In the debate over Wall Street pay, size matters. But it is the size of the bank, not the paycheck, that should be the focus of shareholders and regulators.